Abstract
Twenty-five years ago Richard Epstein published Simple Rules for a Complex World, which would go on to become one of Epstein’s most influential works. This essay, prepared for a conference and symposium to celebrate the anniversary of the book, applies the insights of Simple Rules in the context of one of the most complex areas of social and economic regulation, financial regulation. The complexity of modern finance is often thought to require an equally complex regulatory structure to preserve the safety of the financial system and thus Epstein’s approach is inapplicable to this context. We argue that this argument is exactly backwards. Simplicity in the regulatory framework is essential for financial institutions to manage risk and conduct their affairs efficiently and prudently. Complexity, by contrast, begets a variety of destabilizing problems, including the likelihood of regulatory arbitrage and errors by regulators that increase risk. We argue that refashioning financial regulation around Epstein’s concept of simple rules would create a more stable and efficient financial regulatory system.
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Notes
One frequently cited source concluded that Dodd–Frank contained 390 required rulemakings. (Polk, 2020). This estimate excludes any additional compliance costs from non-mandated rulemakings.
While our main concern in this paper is the U.S. Financial System, our discussion, at times, traverses national boundaries and includes discussion of international standards and regulations.
Mr. Mufarrige was, in 2019, the CFPB’s designated Deputy to the FSOC.
For an overview of the intellectual history of the Socialist Calculation Debate, see Lavoie (2015).
For example, setting the marginal rates of substitution between any two commodities or factors are all the same in all their uses. (Hayek, 1945).
Id.
Indeed, long after the calculation debate ended many mainstream academic economists, including noted Keynesian Paul Samuelson, continued to believe and predict that the Soviet Union would outpace the United States in terms of economic growth. Obviously, Samuelson et al. were wrong, but an often overlooked question is why were they wrong? See https://www.econlib.org/archives/2009/12/why_were_americ.html.
We recognize and appreciate that Ludwig von Mises arguably deserves even more credit than Hayek because Hayek was to some extent merely extending Mises’ original argument to combat developing permutations of command and control approaches. See e.g., Mises (1930) (originally published in German in 1920).
Law, Legislation, and Liberty’s epigraph is a quote from Montesquieu, “intelligent beings may have laws of their own making; but they also have some which they never made.” Though Hayek understood that modern civilization had discovered how best to overcome limitations of knowledge, he also recognized that man is naturally inclined to question spontaneous systems. See Hayek (1976).
Hayek referred to these rules as thesis rules, id.
See also Zywicki (2003).
Notably, Richard Posner’s model of law and economics follows much the same analytical route, with the judge serving as the central planner seeking to set the “correct” prices at the margin to guide individual behavior. See Zywicki and Sanders (2008).
In an article describing the basic functions of the Office of Information and Regulatory Affairs (OIRA), Cass Sunstein—a leading proponent and implementor of Dodd–Frank—reveals a misunderstanding of Hayekian knowledge when he states that “[t]he Hayekian theme emphasizes the dispersed nature of human knowledge and OIRA’s role in attempting to acquire as much of that knowledge as possible, primarily through careful attention to public comments.” Sunstein (2013). But Sunstein’s claim turns Hayek on his head. “Hayek is not interested in the centralization of knowledge for knowledge's sake. Rather, he is interested in the way in which certain institutions (such as prices, language, and traditions) centralize huge amounts of information, boil it down into tacit knowledge, and then redistribute it to decentralized decision-makers in the form of prices, rules, traditions, etc. The ‘purpose’ is not to collect the information at the center in order to make it more ‘accurate’ or ‘better’; the purpose is to send it back out to decentralized decision-makers in order to allow them to better coordinate their affairs with one another.” (Zywicki, 2005).
Daniel Klein distinguishes between two different types of market “coordination,” concatenate and mutual coordination and argues persuasively that distinguishing between the two when describing market activity helps clarify the conversation. Klein (2012).
See also Polanyi (1951, p. 159). “An authority charged with replacing by deliberate direction the functions of a large self-adjusting system, would be placed in the position of a man charged with controlling single-handed a machine requiring for its operation the simultaneous working of thousands of levers. Its legal powers would avail it of nothing. By insisting on them, it could only paralyze a system which it failed to govern.”.
See Buchanan (1964) (“The network of relationships that emerges or evolves out of this trading process, the institutional framework, is called “the market.”).
A similar analysis of the global financial regulatory system to that presented here is provided by Denahy (2015), who also draws on Hayek’s concepts to provide a critique of the financial regulatory system and calls for greater governance by simple rules instead of complex standards.
Kling highlights this issue in his review of Friedman and Kraus’s volume, “For example, suppose that the required return on equity for a bank is 12 percent, but it pays 4 percent interest on its debt. In that case, an asset funded 8 percent by equity and 92 percent by debt will have a blended financing cost of 4.640 percent. An asset with only a 20 percent risk weight would require only 1.6 percent in equity and 98.4 percent debt, for a blended financing cost of 4.128 percent. In this example, the bank can accept a lower interest rate of about one-half of one percent on the asset that falls into the low-risk bucket, simply based on regulatory capital requirements. The larger the difference between debt and equity cost, the greater the extent that banks are steered toward assets deemed low risk by regulators.” (Kling, 2015).
Id.
Taylor (2009).
As Haldane and Madouros have noted, the Basel Accords themselves have evolved from a set of relatively simple rules in Basel I to a more complex regulatory regime in Basel II. They argue the complexity of the Basel II rules contributed to the financial crisis and that a simpler framework would have performed better. They go on to note that Basel III is still more complex, suggesting that these lessons have not been learned. (Haldane & Madouros, 2012).
Chairman Hensarling introduced this idea in the Financial Choice Act, proposed in 2017. See Paul H. Kupiec, Higher Leverage Ratio is Hardly a Big-Bank Giveaway (Feb. 10, 2017), available in https://www.aei.org/articles/higher-leverage-ratio-is-hardly-a-big-bank-giveaway/ (originally published on AmericanBanker.com).
In recent testimony regarding the obligation to collect small-business lending data by the Consumer Financial Protection Bureau, for example, Diego Zuluaga highlighted the high costs imposed on small financial institutions to report that data but those banks make very few such loans in terms of volume and expense. (Zuluaga, 2019).
Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub.L. 111–203, 124 Stat. 1376 (2010).
See e.g., CFTC Margin Rule, 81 Fed. Reg. at 681.
The assets must be transferred to a third-party custodian. Ownership of the assets remains with the posting party. See e.g., CFTC Margin Rule, 81 Fed. Reg. at 687.
See ISDA, Initial Margin for Non-Centrally Cleared Swaps: Understanding the Systemic Implications (November 2012); see Craig Pirrong, Clearing and Collateral Mandates: A New Liquidity Trap?, 24 J. APPLIED CORP. FIN. 67 (Winter 2012).
CFTC OIG, A Review of the Cost–Benefit Consideration for the Margin Rule for Uncleared Swaps (2017).
As Hayek notes, this means that “equilibrium” is best understood as an individual phenomenon where an individual’s expectations come to fruition, rather describing an impersonal social or economic phenomenon.
Denahy (2015) characterizes this effort to increase systemic resilience through containing shocks and preventing them from becoming contagions as “modularity.”.
See Zywicki (2015) (summarizing studies).
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Mr. Mufarrige is an attorney at Wilson, Sonsini, Goodrich and Rosati. He was previously a senior adviser in the Director’s office at the Consumer Financial Protection Bureau. The views expressed here are his own. Todd Zywicki is George Mason University Foundation Professor at Antonin Scalia Law School and a Senior Fellow of the Cato Institute. We thank Nicholas Anthony and Wallace DeWitt for helpful comments on an earlier draft of this article.
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Mufarrige, C., Zywicki, T.J. Simple rules for a complex regulatory world: the case of financial regulation. Eur J Law Econ 52, 285–305 (2021). https://doi.org/10.1007/s10657-021-09698-2
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DOI: https://doi.org/10.1007/s10657-021-09698-2